Consider Recent Selloff A Rehearsal For Volatility To Come – Amundi

By Michael Aneiro

That late-July selloff that hit high-yield bonds particularly hard was basically a dress rehearsal for likely bouts of volatility ahead, according to Amundi Smith Breeden, which uses an extensive theater metaphor to describe how markets behaved:

As July came to a close, market participants were once again rehearsing a rush for the exits. Years of rising prices and falling volatility have “packed the theater” by encouraging the accumulation of risk positions. At the same time, many of the theater’s exit doors have been blocked by considerable reductions in the number and risk tolerance of market intermediaries. For banks and dealers, the combination of de-leveraging, re-regulation, and transparency requirements have all played a part. It is predictable that as theater-goers anticipate the end of global monetary stimulus that there will be bouts of selling and rapid market re-pricing….

What is an investor to do? “Be ready to sell before everyone else can sell” is not a sturdy foundation for an investment strategy.

Amundi Smith Breeden says it expects this pattern to repeat over the next several quarters and advises investors to keep an eye on market fundamentals, to be ready for “flares in volatility—especially in fixed income,” to view cash as a valuable option rather than a drag on returns, and to use any further selloffs as buying opportunities. All of this is especially important as the Fed gets closer to announcing its rate-hike strategy, with such an announcement possible as early as next month. More from Amundi:

Of course, all of this is easier said than done. The main point is to anticipate volatility and plan a response that creates value rather than destroying it. Much of the rent that used to flow to banks and brokers for making markets will accrue to others this time around. These beneficiaries will likely be characterized by patience, discipline, and a longer-than-average investment horizon, which is not that high a hurdle to clear in this daily mark-to-market….

We view the current episode of risk reduction as more of a financial market drill than an economic event. Interest rate markets have not been priced with an appropriate premium for possible interest rate increases.